Capital gain: two words that can prompt both elation and dread. You made money, it’s time to celebrate! But now you owe capital gains tax on those earnings, and that can hurt.
To take the sting out of the taxman’s bite, it’s important first to understand what a capital gain is and why we pay a specific type of tax on these earnings. Then, armed with this knowledge, we can implement one or more strategies to help minimize our tax bill.
What is a capital gain?
A capital gain occurs when a real asset you own appreciates in value. Real assets are tangible assets, such as land, art, collectibles or stocks. When a real asset appreciates in value, it’s known as a capital gain. If it depreciates, it’s known as a capital loss.
The idea behind these rules is to incentivize people to invest for the long-term in real property or assets. Think back to a time when our society was more agricultural, and farmers would have to invest in large, expensive machinery. Depreciation on that machinery was considered a capital loss that offset the capital gain earned on the value of the farmer’s land.
When to pay capital gains tax
When you sell an asset for more than you paid for it, you have a capital gain and owe taxes on that gain.
In the vast majority of cases, you do not pay tax on a capital gain (the increased value of an asset) until you sell the asset.
If you change how an asset is used, such as converting your principal residence into a rental property, that’s considered a deemed disposition. You may owe capital gains tax once that change occurs, but can defer payment of that tax until you sell the property (more on that below).
For example, if you buy stock for $15,000 then later sell it for $25,000, you’ll have a $10,000 capital gain and owe taxes on that gain (for simplicity’s sake, let’s assume no interest or dividends were also earned).
The taxes paid on this type of earning is called capital gains tax. While the name isn’t all that inspiring, if you understand some basic facts, you can appreciate when and where to use legitimate strategies to minimize the tax owed:
- Capital gains tax has a universal inclusion rate of 50%, meaning you are only taxed on half your profit.
- The inclusion rate is the same for everyone, but the amount of tax you pay depends on your total income, personal situation and your province of residence.
- If you had earned the same amount as income (or as interest), you would owe tax on the full amount as there is no inclusion rate for these types of earnings.
- The tax you pay is calculated based on your marginal tax rate, so the less you earn in a calendar year, the lower your marginal tax rate, and the less overall capital gains tax you’ll be required to pay.
Bearing this in mind, you can now consider these six capital gain tax strategies to maximize your earnings and reduce your taxes:
Strategy #1: Time your earnings
Since your capital gains tax rate is determined by your marginal tax rate, you need to pay attention to your overall earnings during each calendar year. The lower your income, the lower your marginal tax rate—which results in a smaller piece of pie going to the tax man.
For instance, if you have an investment property you want to sell, time the sale of that property for soon after January 1 in any given year. Because capital gains tax is owed in the calendar year in which a property is sold, that gives you 16 months before you owe tax on those earnings (in April of the following year).
Another option is to wait and sell a real asset during a year when you know your earnings will be less (say, when you take a sabbatical from work or when one spouse goes on maternity leave).
For instance, if you sold a condo you rented out for a profit of $65,000 when your annual earnings were $100,000 (and for simplicity, we’ll assume you live in Ontario, you’re single and don’t contribute to a registered savings plan or pension or have any other deductions) then you’d owe approximately $38,515 in federal and provincial tax, and have an average adjusted tax rate of 23.34% and a marginal tax rate around 43%.
If, however, you sold the condo when your income was $50,000, your marginal tax rate would drop to 31.5% and you’d end up paying approximately $17,880—for a savings of $20,635.
The key to using this strategy is to sell an asset during a year when your income is low. For those operating small businesses, this could mean selling in a year when you will incur more expenses as these deductions will help reduce your income, which reduces your marginal tax rate and the amount of capital gains tax you will owe.
Strategy #2: Defer your earnings
One smart strategy is to defer your earnings on the sale of an asset because you only owe tax on earnings received.
Assume your annual earnings are $50,000 and the sale of a property earns you $100,000 in profit. Without deferring the earnings, you’d owe approximately $24,480 in taxes in the first year (recognizing your earnings plus the full capital gain in that first year) and about $8,000 in tax each year after, for a total tax hit of $48,480. If, however, you asked the buyer to stagger payments so that you only received $25,000 in each of the next four years, the total tax bill would be approximately $46,820—resulting in a tax savings of $1,660. It doesn’t sound like a lot, but when you apply actual deductions, such as RRSP contributions, charitable donations, and self-employment expenses, the tax savings can really add up.
This deferment strategy is known as the Capital Gains Reserve and there are a few rules to follow when you apply it:
- Generally, the capital gains reserve can be claimed for up to 5 years;
- There must be a minimum (cumulative) 20% income inclusion each year. (Put another way, you must pay tax on a minimum of 20% of the earnings in each calendar year);
- The five-year time frame can be extended to 10 years in certain situations, such as the sale of a Qualifying Small Business Corporation (QSBC) or the transfer/sale of shares to a child or grandchild.
Strategy #3: Create tax deductions
Another strategy to reduce the amount of capital gains tax owed is to seek out and trigger capital losses or find and claim tax deductions.
To offset capital taxes owed, consider selling stock or assets at a loss. The capital loss can be used to reduce capital gains and reduce taxes owed on those earnings.
There are a few rules when it comes to applying this strategy:
- The asset you sell must be sold for fair market value. You cannot create a superficial loss by selling the asset for less than it’s worth in the open market;
- To use the loss to offset income or capital gains, the asset sold cannot reside in a registered account, such as an RRSP, RESP, RDSP or TFSA.
Another option is to use tax shelters to help minimize taxes paid.
For example, if you were to take the extra cash earned from the sale of a real asset, such as an investment property or stock, and use it to make a larger RRSP contribution, you could offset the tax paid with the tax rebate from the contribution. This strategy is particularly useful when an individual has significant unused RRSP contribution room from prior years.
Another, riskier option is to purchase a tax-favoured investment, such as flow-through shares. Tax-favoured investments can be used to defer the tax payable in the year a large capital gain is generated—but be sure you understand the risks. There is always the chance that your purchase will depreciate to zero. Remember, flow-through shares invest in small start-up resource companies without enough profits to write off their expenses. The tax advantage is that these companies are allowed to pass their expenses off to shareholders, who can deduct those expenses from their income. But the companies are small start-ups, and are likely to have a much higher-than-average failure rate. (For more, read “When does investing in flow-through shares make sense?”)
Strategy #4: Avoid a large tax bill as a retiree
Retirees need to pay particular attention to fluctuating annual income as a large increase in taxable income in one year not only means higher taxes, but can trigger claw-backs of government income-based benefits, such as Old Age Security (OAS).
In this case, you might consider a capital gains tax strategy that also works for reducing overall taxes owed: Split your income. In Canada, married and common-law couples have the option to split the pension income they earn with a spouse. By splitting your income with a spouse who earns less, you reduce your annual income earned, which is used to calculate eligibility and potential claw-backs of OAS or the age tax credit. A lower annual income also means a lower marginal tax rate, which means you can proactively implement a capital gains tax strategy of timing your earnings—only disposing of a real asset when your earnings and marginal tax rate are lower.
Another good option is to use a Tax-Free Savings Account (TFSA) to shelter future investment income from tax and minimize or avoid reductions in federal income-tested government benefits.
Strategy #5: Give it away
Rather than selling an asset, paying capital gains tax on the earnings and then using those earnings to make charitable donations, consider donating the asset instead.
For example, if you plan to make a $1,000 donation to a charity, donate stock with a market value of $1,000 (but which cost you less to purchase). Making the donation in stock entitles you to the $1,000 charitable receipt for tax purposes, while not triggering capital gains tax.
Be mindful, however, that the same benefits do not apply when gifting assets to family. For instance, if you gave the family cottage to your adult child, you would not avoid paying capital gains tax on that property. According to the Canada Revenue Agency (CRA), a gift is a taxable disposition which triggers capital gains tax.
If, however, the property (or real asset) lost value (and you can back this up with evidence), then gifting it to a family member would be beneficial, as it would keep the asset in the family and create a capital gains loss that can be applied against other investment earnings.
Strategy #6: Use the lifetime capital gains exemption
The final strategy applies to small business owners, farmers, and those who own and operate a fishing property. The assumption here is that over the years your venture was profitable and, upon retirement, you choose to sell or gift the venture (a deemed disposition).
As soon as the business is sold, you will incur a substantial capital gains tax bill. To reduce this burden (and encourage small business growth), the CRA offers a lifetime capital gains exemption. The Lifetime Capital Gains Exemption is a lot like the Principal Residence Exemption, only with a cap on the amount you can shelter from tax.
For small business corporation shares, the cap on this exemption in the 2018 taxation year is $813,600 (down from $835,716 in 2017); for qualified fishing and farming properties, the cap in 2018 is $1 million.
This means you could shelter up to $813,600 from tax on the sale of your business or up to $1 million on the sale of your farming or fishing property.
Of course, there are rules on how this exemption is applied:
- For the two years prior to the sale of the business, only the owner or a person related to the business owner may own the shares of the company.
- In order to qualify for the exemption, 90% or more of the value of the business’ assets must be used for carrying on an active business in Canada. Keep in mind that 90% portion can include shares or debt in other small business corporations, as long as they are considered active businesses in Canada.
- Finally, more than 50% of the business’ assets must be used primarily in an active business in Canada over a two-year period.
- For a farm or fishing property, the owner must be able to prove that the primary source of income was from farming or fishing.
A common strategy is to “purify” a company prior to the sale. This includes taking action to dispose of or change the structure of the company to meet rules listed above, so that when you sell or transfer shares of the business this transaction would qualify for the lifetime capital gains exemption.
Be careful with “creative” tax strategies
Finally, it should be pointed out that many real estate investors make the erroneous assumption that they can shelter the profit earned from the sale of an investment property either by trying to create a principal residence scenario or trying to pass off business income as a capital gain.
The assumption is that by owning the property for a specified period of time—say six months to a year—and getting utility bills sent to the address under the owners’ name, the property can be designated as a principal residence. This isn’t true.
The CRA has very clear definitions as to what qualifies as a principal residence, and how long you own property is not part of those definitions.
More importantly, the CRA is now wise to the attempts of some real estate investors who attempt to dodge taxes.
As a result, real estate investors need to be very precise about the status of their investment: Is the asset part of a business plan to earn income or is it a real asset investment? For instance, if you are investing as part of a business model—flipper, AirBnB operator, property management—the income earned and the sale of the property are subject to income tax, not capital gains tax.
While it goes without saying, we’re going to say it: Be sure to talk to your tax advisor about any capital gains tax strategy before you attempt to implement it. Taxes should never lead a personal finance decision; rather, tax strategies should be a contributing factor to each decision. Be sure you know the advantages and disadvantages before setting any strategy in motion.
MORE FROM ASK A REAL ESTATE EXPERT:
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- Does it make sense to sell two condos to buy one pricier home?
- Should you buy real estate just to stay in the market?
- Capital gains surprises on the sale of your co-owned cottage